Stock investors got a gutcheck Monday when long-bond yields hit levels not seen since June 2004, when the Federal Reserve delivered what would be the first in a long series of rate hikes. Bond yields at 19-month highs might send such bearish signals that they could spark a near-term correction, several strategists predict. High fixed-income payouts compete with equities, and if the yield of the 10-year Treasury bond continues on its way to 5%, it could become an ever more attractive, risk-free alternative to stocks. The S&P 500 index, for instance, returned 4.9% in 2005, including dividends. On Monday, the benchmark 10-year Treasury bond fell 12/32, while its yield, which moves inversely, rose to 4.73%. Long-bond yields tend to rise on expectations of rising inflation. Stocks closed above their worst levels, but the bearishness was palpable as the market ignored declining crude-oil prices and a megamerger in the telecom industry. Crude oil dropped 2% to $62.1 per barrel on expectations that the Organization of Petroleum Exporting Countries won't cut production this month and amid hopes of easing tensions with Iran. News that AT&T ( T) reached an agreement to acquire BellSouth ( BLS) for $67 billion fired up the telecom sector, which is expected to see matching expansion from the likes of Verizon ( VZ). The Amex Telecom Index rose 1.53%. But the enthusiasm didn't spread to other sectors of the market, with investors nervously eyeing bonds. The Dow Jones Industrial Average dropped 63 points, or 0.57%, to 10,958. General Motors ( GM) bucked the trend after selling most of its stake in Suzuki Motors. The S&P 500 lost 0.7% to 1278 and the Nasdaq Composite lost 0.7% to 2286. Research in Motion ( RIMM) also bucked the trend after announcing Friday it would pay $612.5 million to settle its patent dispute with NTP.
The reason 10-year yields are rising, besides an auction scheduled for Thursday, is the market's realization that the economy is going to rebound from weakness in the fourth quarter. After a spate of strong economic data over the past month, that trend should be seen again in Friday's February employment report. The economy is expected to have added 210,000 jobs last month. With the threat of a slowing housing market casting a large shadow over consumption and the economy this year, the bond market took a while to react to signs of an economic pickup. On Monday, however, it ignored news that the National Association of Realtors' pending home sales index had dropped 1.1% in January from December, a 4.8% year-on-year decline. According to Barry James, president of James Investment Research, "While the housing market is showing signs of slowing, no one expects a rapid downturn." Economic strength should keep the Fed on a tightening course. The market now sees 100% odds that evidence of growth will lead the Fed to continue hiking rates to 4.75% on March 28 and odds of 80% it will hike to 5% on May 10. These expectations also pushed the yield of a two-year note, which closely tracks Fed moves, up to 4.76% on Monday. But since last week, the bigger move upward has been in longer-dated Treasury yields. As the 10-year yield rises, it's partly undoing a market configuration that had many worried about the economy. The yield curve, which plots the yields of short- to long-term bonds, has been inverted since late last year, as short-term yields rose above long-term ones. Normally, investors seek higher yields to compensate for the inflation risks associated with long-term fixed returns. A yield-curve inversion, meanwhile, has historically signaled an economic downturn or recession 12 months down the line, as it did in 2000.
But now that the yield curve is flattening again, stock market investors are worried that inflation and the Fed will continue to pressure stock prices, says Owen Fitzpatrick, head of the U.S. equity group at Deutsche Bank. And, in the meantime, bond yields are starting to compete with stocks. "It might take away from the concern over the inverted yield curve, but it's a negative," Fitzpatrick says."We hadn't seen yields at these levels in a long while." There are also other pressures on long-bond yields. Last week, the European Central Bank hiked rates to 2.5% and the Bank of Japan, which meets later this week, is expected to start unraveling its 5-year-old zero-rate policy. To compete, U.S. yields must rise. For James, the current interim period -- in which the housing market is slowing, first-quarter growth is rebounding, inflation pressures are building and the Fed keeps raising rates -- will likely create enough confusion to soon trigger a correction in stocks. He's not the only one to have made that call recently.
As noted here , market guru Woody Dorsey expects a correction in the 6% to 12% range to begin shortly. And on Monday, Merrill Lynch strategist Bob Doll said that rising bond yields "could cause a near-term market correction." Jeffrey Saut, market strategist at Raymond James, is also cautious in the near term. Although he notes all the factors mentioned above, Saut also points out seasonal factors, much as Dorsey did. "Since 2000, the month of March has been a turning point for the equity markets, both on the upside and the downside," Saut wrote in a note to clients. "Given our current mindset, we obviously think the markets have made a top."